The Analysis of a Failed Bank

As many of you already know if you follow me on the Yahoo message board, a good friend of mine who was an executive at Silverton Bank based in Atlanta, told me a bit about the bank failure and how the FDIC came in and took control with no warning.

This one hits home a little hard for me since he and his family are very close. My son grew up with his son, my wife plays tennis with his wife, his daughter baby sat my daughter, he was the one that got me into boating. I know how dedicated he was to making the bank as successful as possible.

To hear his voice in total defeat and in a state of shock was difficult for me. But I wanted to know how something like this could happen if banks are truly getting healthier as we have been hearing. This information could be considered inside information before the collapse but now that the collapse has happened, it is public knowledge.

His bank, like many others of the same size, just flat ran out of money. How does a bank run out of money? Basically, the losses out weigh the gains for so long that the amount of capital remaining is much lower than the paper losses on the books. For Silverton, they had some profitable divisions, much like B of A, JP Morgan, Wells Fargo, etc. These are the divisions that deal with everyday activities such as short term loans (less than a month), capital investments, and capital management (services). All were doing very well.

But the profits from these divisions, while at record levels, were far less than the paper losses with regard to defaulted loans and other bad assets. In fact, it isn't even close. I don't know the numbers but it sounds like the loan losses were so huge, the capitalization of the bank eroded very quickly. Basically, the bank become insolvent due to paper losses exceeding capitalization. The profitable divisions were helping the capitalization, but it was like using a garden hose to fill a lake which had a broken dame.

So the FDIC came in with suits, briefcases and weapons to take over the bank quickly, swiftly and with no doubt who was now in control. The FDIC agents work side by side with the bank workers to go through every account, go through every balance sheet, figure out how much liquid assets the bank has, transfer accounts to other banks, and all the bad loans end up with the FDIC for a total loss to the taxpayers of $1.3 billion.

The bankers in general did not see it coming. They knew they were in trouble. They tried to move the bad loans for months but there were no takers. They tried to get loans themselves to help with capitalization but there was no credit lines open. They were insolvent and the FDIC did what it had to do to protect the clients. They have to make the transition in 3 days so both the FDIC agents and the bankers work all weekend to move accounts and close up shop.

I want to make this clear, I know probably about 1% of what actually happened. So this is not gospel. But, this sure does sound, and feel like what the state is of many of the major banks. B of A, JP Morgan, Morgan Stanley, all reporting record earnings. But we don't know what is on their books. The Fed knows. The FDIC knows. And some day, we may know.

The FDIC can easily take over a small to medium sized bank. But taking over a major bank like B of A would be substantial and would take months, not a weekend. So the Fed and FDIC want to make sure these banks do not go under, even if they are insolvent. Bad assets need to move off of the books from these banks as soon as possible to avoid collapse via a run on the banks. You can be assured that your money in the bank has been loaned out many times over. The FDIC will continue to insure it as long as they have money to insure it.

But how deep are the FDIC pockets? Can they continue to take on these bad loans and pay out billions each week on bank collapses?

I think we will be getting more clarity in the situation as the weeks and months unfold. Commercial real estate loans are unravelling. Talking with a commercial real estate officer in my neighborhood, he said what you will find out there is the really good real estate is bringing in money still. What is collapsing right now are the strip malls that are not in prime locations. They are losing money at an accelerated pace. This is causing renegotiation's on leases for restaurants, hotels, retail shops, malls. He said they are very busy but a lot of the work revolves around renegotiating leases and moving retail shops out of poor locations and into better locations.

Well, my fingers are tired and I will close on my disclosure. I am short AXP, BAC and I feel good about both. I am looking at attacking REITs with puts but I do continue to hold SRS and feel decent about this but the market seems to be manipulated. I do believe we may have some run up on the market this week perhaps but I am not over extended so I can take the punishment so I also own SDS with covered calls.

If the SPX gets under 850, I will add to my short positions. Otherwise, I will hold and wait for the MM's to shake out more shorts before the big leg down starts. Good luck, and this is no position to get over extended on the short or long side.

ADDENDUM:

I wanted to point out a few points about Silverton's collapse

1. They felt like they were capitalized enough. The FDIC shutdown was a surprise.
2. They were having record earnings in others parts of the business. Loans is what dragged them down.
3. They were not able to move any of the loans and were not able to raise capital on their own.

Does this sound similar to any other banks you know of?